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We’ve talked about annuities before on this website, but according to the
Association of British Insurers only 23% of those people approaching
retirement actually understand what an annuity is. So we thought it
might be an idea to go through the basics as it’s so important to
understand annuities before you actually retire.
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It’s not complicated. Essentially an annuity is a contract between an individual and an insurance company. You pay over a capital sum from your pension pot and, in exchange, the insurance company pay you an income for the rest of your days. That’s it in a nutshell. Understand this concept and you have the basics of what an annuity is all about.
It used to be compulsory to buy an annuity by the time you reached 75 and, although the rules have now changed, most of us will still need to buy an annuity. Just for the record, the change recently introduced allows you to opt out of buying an annuity if you can prove that you have a pension income of £20,000 a year. Not many of us are in that bracket.
The insurance company will pay you a percentage on the amount of your pension capital that you have handed over to them. This is known as the annuity rate. If the annuity rate is 5% you will get a ‘pension’ of £5,000 a year for every £100,000 that you pay over to the insurance company. The annuity rate that you get will vary according to your personal circumstances and this is one instance where poor health can actually be beneficial in financial terms. Obviously the insurance companies don’t want to pay out any longer than they have to and therefore an overweight smoker with a drink problem is far more likely to die younger than a fitness fanatic, so the latter type get a lower rate than the former. See our article on Enhanced Annuities for further information on this aspect of annuities.
Over recent years annuity rates have been dropping quite dramatically as we have been in a period of low bank interest rates. Over the last 10 years or so, annuity rates have fallen by about 30% so it is vital to save as much as you can into your pension pot before you have to buy the annuity.
The other important thing to remember is that you don’t have to buy an annuity from the same company that you have your pension with. You can shop around for the best annuity rate.
What about inflation? Living on a fixed income can be a scary prospect for a newly retired pensioner (or anyone else come to that). If you have a fixed income then inflation will eat away at your buying power and year on year the same amount of money will buy less in the shops. Our very own Retired Old Blogger has indicated that pensioners are worse off by over £700 this year compared to last. You can overcome this issue by buying an inflation linked annuity whereby the amount paid each year increases with inflation. The downside to this seemingly obvious ploy is that the initial annuity rate is very substantially lower. Insurance companies are not philanthropic.
Finally spare a thought for what happens after you peg out. If you take out an annuity on your life alone, the payments will stop as soon as you die. If you pass away six months after taking out the annuity that’s just too bad. Your spouse won’t get anything and the payments will stop. The way around this problem is to take out a joint annuity that continues to pay out to the surviving partner. You will, of course, be faced with a lower annuity rate because the insurance company are likely to have to pay out for a longer period of time, but you get peace of mind and your partner won’t be cursing you for leaving them with a much reduced income.